Emerging markets - prepare for a roller-coaster
Posted by: Brian Dennehy
Emerging markets have had a great year. History suggests that this uptrend could be at an early stage, revealed here. And valuations remain attractive. But you shouldn't relax too much, as we explain.
So far this year the average emerging market fund is up 22%, and the best fund is up 36% (Baillie Gifford Emerging Markets GrowthAnalysis Save to my funds Add to basket). China has been a key motor, as set out in last week’s blog (China: the Long March upwards) and the longer term outlook for China appears attractive. Recent research from Bank of America (BofA) has added to this rosy picture.
For example, BoA identify 6 bull markets in emerging markets since 1976. On average they rise 230% and this one is up 60% so far, from January 2016. If "average" repeats itself they will double over the next two years.
But you must be very wary of becoming over-confident based on an average of six very disparate periods. Based on two of the six examples emerging markets only have another 25% to go.
This sort of analysis (this time by BofA, but we have all done it) can be very seductive, like the elegant maths of the "efficient market" guys, and their cousins who bet the house based on a number being attached to "risk" - even the Queen rumbled that one in 2008 - "why did nobody see it coming?".
Bottom line is that we can all make a good case for emerging markets, and we have - valuations, money flows, demographics etc. But there is an elephant in the room - no, more a T Rex. The US stock market is not just over-valued. Nor just exceptionally over-valued. It is now uniquely over-valued.
In parallel, sentiment recently hit rock bottom in the US dollar (best seen on a chart versus the euro, where sentiment went sky high). It looks as if that might now be reversing. Oftentimes, the best time to buy a currency exposure is when sentiment is rock bottom - it is a contra cyclical indicator which we have often successfully applied with buying gold (see HERE).
When the US stock market falls sharply (it is not an "if") we should expect overseas markets to fall more so (if history is a decent guide), with emerging markets in the vanguard of those falls.
Similarly, previous Emerging Market bear markets have typically been associated with a stronger dollar.
For all the reasons that emerging markets are attractive now, they will have bounce-ability in the wake of sharp falls. You just need to think through now whether you want to suffer falls of, say, 50%, or whether you would rather take evasive action sooner. More on that HERE discussing contingency plans.